01 equity portfolio management

The information ratio for active management is higher than the ratio for passive management." trade-"My optimization approach limits risk by using a factor model that takes into account

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Test ID: 7428130

Equity Portfolio Management

ᅞ A)

ᅚ B)

ᅞ C)

Questions #2-7 of 106

Which of the following is most accurate regarding equity style index methodology? If style is viewed as a quantity then:

stocks will be placed in either value or growth indices with no overlap

the market cap of some stocks will be split between value and growth indices

there will be a neutral style index category

Explanation

If style is viewed as a quantity, then there will be overlap when the style index is constructed Some of a stock's market capmay be assigned to value and another part could be assigned to growth This would occur when a stock is not clearly value orgrowth Whether style is viewed as a quality or a quantity does not affect whether there will be a neutral category

Mavis Borchard, principal of Borchard Investments, is discussing portfolio strategy with Wilford Tupper, a potential client whowalked into her office in the hopes of finding a shrewd way to invest an $800,000 IRA roll-over Tupper is an experiencedinvestor with other stock holdings, but he does not have the time to manage his own account

After listening to Tupper's investment goals, Borchard suggests a policy of active management, listing several of its benefits

"The potential returns of this strategy are higher than those of passive-management strategies, yet the risk-reward off is appealing The information ratio for active management is higher than the ratio for passive management."

trade-"My optimization approach limits risk by using a factor model that takes into account the covariance of different riskfactors."

"To ensure that my portfolios deliver the best performance and that I don't deviate from my original investment style, Iregress my returns against three indexes, a large-cap, a mid-cap, and small-cap."

"I use a bottom-up approach to select stocks, focusing most on industry conditions."

Tupper is not satisfied with Borchard's strategies and asks about other types of investments Historically, Tupper has not beensuccessful at beating the market with his large-cap stock choices, but he is a firm believer in reversion to the mean

Borchard then recommends an enhanced indexing strategy She suggests that Tupper start with 60 percent of his money in amarket index fund, then divide the remainder between two portfolio managers, one who manages accounts in a large-capblend style, and one who buys small-cap stocks with a value slant Borchard expects the risk-free return to remain at 4.3percent for the rest of the year and projects a market return of 12.7 percent and market risk of 18.6 percent for the year Thefollowing is some data on expectations for both investment managers Assume the correlation between the equity manager'sactive returns are zero

This plan appeals to Tupper, but he is still not sure in what index he should invest He is picky about his indexes and would like

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Question #2 of 106 Question ID: 466173

any selections to meet a number of criteria:

The index must be investable

Transaction costs must be low

The index value must be easy to track

Index construction must allow investors to mimic the index with minimal tracking risk

The index must reflect the broader market as closely as possible

While Tupper likes the mix of index funds and active management proposed by Borchard, he is also concerned that the activemanagers stick to their knitting Borchard generally uses a large-cap index like the Dow Jones Industrial Average as a

benchmark, but Tupper wants a benchmark customized to each manager's investment style Borchard reluctantly agrees toprovide a customized benchmark She generally uses returns-based analysis to track whether money managers stay ontarget, but Tupper prefers a holdings-based approach

To best meet Tupper's index requirements, Borchard should select:

an index reconstituted by committee, rather than by rule

a capitalization-weighted index

a price-weighted index

Explanation

Borchard seeks an index that reflects the broader market as closely as possible This suggests a price-weighted index is out,

as nominal stock prices are somewhat arbitrary and quite changeable, so the index's complexion can change simply because

of a stock split Low transaction costs favor capitalization-weighted indexes rather than equal-weighted indexes that must berebalanced more often The investability requirement also weighs on equal-weighted indexes, which tend to favor smallerstocks, which in turn may offer less liquidity That leaves a capitalization-weighted index Most indexes are easy to track Indexreconstitution policies can affect tracking risk and transaction costs, but are not relevant to investability and how effectively anindex reflects the market (Study Session 11, LOS 23.d)

Which of Borchard's statements is likely to be most effective at convincing Tupper to let her actively manage his account?

"The potential returns of this strategy are higher than those of

passive-management strategies, yet the risk-reward trade-off is appealing The

information ratio for active management is higher than the ratio for passive

management."

"To ensure that my portfolios deliver the best performance and that I don't deviate

from my original investment style, I regress my returns against three indexes, a

large-cap, a mid-large-cap, and small-cap."

"My optimization approach limits risk by using a factor model that takes into account

the covariance of different risk factors."

Explanation

None of the arguments is particularly compelling, but at least the statement about the information ratio is true and relevant.Active management does have a higher information ratio than passive management Optimization applies to passive orsemiactive management, not active management Regressing returns against cap-weighted indexes will not determine

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whether the fund emphasizes value or growth stocks, so it will not detect growth or value style drift Bottom-up approachesdepend little on industry conditions, relying mostly on the fundamentals of individual stocks (Study Session 11, LOS 23.b)

Assuming a 30 percent weighting in large-cap stocks, Borchard's enhanced indexing strategy for Tupper should generate anactive return closest to:

Which of the following statements about holdings-based analysis is least accurate? It:

can yield different results depending on the method used

can pick up style drift faster than returns-based analysis

requires the use of less data than returns-based analysis

Explanation

Holdings-based analysis requires more data than returns-based analysis The other statements are true (Study Session 11,LOS 23.i)

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A portfolio's active risk is the square root of the sums of the squares of the weighted average active risk.

To calculate the active risk, subtract the expected market risk from the risk of each portfolio component The large-capstrategy's risk is 27.5% Subtract the market's 18.6% risk, and you have active risk of 8.9% The small-cap strategy's activerisk is 11.5%, and the index fund's active risk is 0%, because the index tracks the market Here's how to calculate the completestrategy's active risk:

Which of the following statements is least accurate? An investor's utility of the active return:

increases as active risk decreases

increases as the investor's risk tolerance for active risk decreases

increases as the investor's risk aversion to active risk decreases

Explanation

The utility function for active return is similar to the utility function for total return The utility of the active return increases asactive return increases, active risk decreases, and as the investor's risk aversion to active risk decreases Risk tolerance is theopposite of risk aversion Lower risk tolerance would imply lower utility from a risky return

Which of the following equity strategies would provide the lowest expected tracking risk?

Risk-controlled active management

Passive

Enhanced indexing

Explanation

Passive management will have the lowest expected tracking risk Semiactive management is also known as enhanced

indexing or risk-controlled active management A semiactive manager will have an expected tracking risk between active and

2 2

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Questions #10-15 of 106

passive managers

Michelle St Jacques analyzes industrial stocks and manages portfolios for Candid Capital, a full-service brokerage in RhodeIsland St Jacques is given charge of the assets of clients interested in a growth-oriented strategy using large-cap stocks.Barnard Walters also manages portfolios for Candid Capital, focusing on a midcap value strategy

Lance Johnson, Candid's investment director, is happy with the performance of client portfolios but concerned about thereturns-based analysis performed about six months ago on both the St Jacques and Walters portfolios Here are the results ofthe analysis:

Style St Jacques Portfolios Walters Portfolios

Johnson decides to do the analysis again, being far more thorough This time, he regresses the returns of portfolios managed

by St Jacques and Walters against a variety of style categories Here are the results of the regression:

Style St Jacques

Portfolios

Walters Portfolios

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ᅚ A)

ᅞ B)

ᅞ C)

While Johnson is working on his regression analysis, St Jacques faces a problem of her own Shares of Wellman Industrieslook appealing at current levels, but the analyst is concerned about the behavior of company management

A half-dozen former executives looted the company and fled to Argentina, leaving Wellman Industries with an attractiveproduct portfolio, a solid market position, and a leadership vacuum Company founder Josephine Wellman has come out ofretirement to take over the firm on an interim basis Her mandate is to increase both investor confidence and managementaccountability, and St Jacques is trying to assess whether her efforts will have the desired effect So far, Josephine Wellmanhas done the following:

Abolished cash bonuses

Tied executives' stock-option compensation to the amount of profit their division generates over the next year

Changed the composition of the board, adding four new independent directors and giving the audit committee morepower

Altered the stock-option program to issue options at higher strike prices than the current price in order to stave off

criticisms about excessive compensation

Required all board members to agree to be legally responsible for their actions while serving on the board

Required all executives to invest 2% of their base pay in company stock every year and not sell any company stock theyalready own

Required all board members to own a sizable stake in Wellman Industries and changed the compensation policy so thatthey receive stock and not cash

In the wake of the second regression analysis, what changes should be made in the analysts' stated investment styles?

Neither St Jacques' nor Walters' stated style should be changed

St Jacques' stated style should change, but Walters' should not

Walters' stated style should change, but St Jacques' should not

Explanation

St Jacques is purported to use a large-cap growth strategy She does have some exposure to midcap stocks and to valuestocks But some overlap is to be expected The definitions of growth and value differ depending on who you ask, and the linebetween large-cap and midcap is blurred She does have a 44% exposure to large-cap growth stocks and a 20% exposure toforeign large-cap stocks Given her growth focus in U.S stocks, we should conclude that the foreign stocks also have a growthslant As such, St Jacques probably has at least a 60% exposure to large-cap growth stocks, and substantially smallerexposures to everything else No other style box is more appropriate than large-cap growth Walters' 56% exposure to midcapvalue does not sound high, but the blurred line between market-cap categories can explain some of that, as he also hasexposure to large-cap and small-cap value stocks Of more importance, however, is the money-market exposure The highexposure to money markets and lack of exposure to other types of fixed-income securities suggest he has taken on a largercash position (money-market funds and short-term bond funds are often used as a cash plug, and a large cash position islikely to have a high correlation with money market or short-term bond returns) While a large position in other fixed-incomeinvestments might suggest a move toward an equity/income blend, the increase in money-market weighting does not

necessarily affect the investment style Many managers routinely hold cash, adding to the cash position during difficult marketperiods and deploying the cash when stocks look more attractive Given some overlap between equity styles and the largeposition in money market funds (cash) the majority of Walters' portfolios is invested in midcap value stocks He remains amidcap value manager (Study Session 11, LOS 23.i)

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Which statement about regression analysis is least accurate?

St Jacques' portfolio composition changed little between the two tests

Correlation probably skews the data

Regression works better for growth and value strategies than for blend strategies

Explanation

In the second analysis, St Jacques' large-cap, midcap, small-cap, and fixed-income weightings changed by no more than 2%.Holdings-based analysis does require more data than the returns-based analysis Johnson used In real life, large-cap growthand value benchmarks are likely to have significant correlation Capitalization-specific benchmarks also have substantialcorrelation While the percentages have value and can help assess a manager's style, the likely correlation between differentstyle categories suggests the numbers are not truly representative of the percentage of the portfolios' returns attributable toprice movements within that asset class Returns-based analysis should work just as well for blend funds as it does for value

or growth funds (Study Session 11, LOS 23.i)

Which of the following is least likely to improve the effectiveness of Wellman Industries' board?

Paying directors with stock

Holding directors legally responsible for their actions

Requiring directors to own shares in the company

Explanation

Holding directors legally responsible for their actions could spark excessive conservatism or drive the best candidates to turndown board service The other actions are all recommended by independent analysts as strategies for improving directorbehavior Adding independent directors reduces management's influence on board actions, which is often a good thing.Paying directors in stock and requiring them to own a stake in the company ties their personal well-being to that of the

company (Study Session 12, LOS 25.c)

The change in regression-analysis data for Walters' portfolios can be best explained by:

a rise in Walters' bearishness

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Josephine Wellman's actions are least likely to spur:

company managers to use equity swaps

company managers to become whistleblowers

company managers to take more risks

Explanation

Tying compensation directly to profitability will probably drive managers of weak departments to take extra risks to boostincome Out-of-the-money options can cause the same problem If managers are required to buy stock, some may opt to useequity swaps to monetize their holdings Company employees are not likely to become more willing to blow the whistle onimproper conduct until they are confident of their anonymity and/or the board's willingness to act, neither of which has beenaddressed (Study Session 12, LOS 25.c)

The first returns-based analysis probably has Johnson least concerned about:

misfit active risk

inaccurate risk measurement

a low style fit

Explanation

Because the regression has fewer variables and doesn't attempt to measure growth or value content, it probably does notexplain too much of the analysts' returns, resulting in a low style fit The use of poor benchmarks often leads to misfit activerisk However, the returns-based analysis is not a risk-measurement tool, and is unlikely to raise concerns about risks thathave not already been sparked by a different type of analysis (Study Session 11, LOS 23.i)

Manager X follows the stocks in a broad market index and has made independent forecasts for 300 of them Her informationcoefficient is 0.03 Manager Y has made independent forecasts for 100 stocks His information coefficient is 0.05 Whichmanager has the better performance and why?

Manager X because she has greater breadth

Manager Y because he has more accurate forecasts

Manager Y because he has greater breadth

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performance as measured by the information ratio because she has a greater breadth of decisions

Which of the following selling disciplines would be best for an investor who is concerned about the tax implications of a trade?

Which of the following is least likely to be a rationale for investing in small cap stocks?

Higher returns are more likely when starting from a smaller stock price base

The higher betas for small cap stocks indicate that their future returns should be

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The price-weighted index

The market capitalization-weighted index

The free float-adjusted market capitalization index

Explanation

The market capitalization-weighted index, also known as the value-weighted index, assumes that the investor holds eachcompany in the index according to its relative weight in the index The price-weighted index assumes that the investor holdsone share of each stock in the index

Which of the following is least likely to be an objective of optimization after decomposing total active return into true and misfitcomponents?

Generate a positive "true" information ratio

Eliminate misfit risk

Maximize total active return

Explanation

The decomposition of the total active performance into true and misfit components is useful for optimization The objective ismaximize the total active return for a given level of total active risk, while still allowing for an optimal amount of misfit risk Notethat misfit risk is not optimized at zero because a manager may be able to generate a level of true active return for some level

of misfit risk In other words, if you let the manager specialize in the style they are familiar with, the manager is more likely togenerate excess returns relative to their normal portfolio

Which of the following is least likely to be a reason pricing inefficiencies exist on the short-side?

There are more potential buyers than sellers of stock

Management has options in firm's stock

The securities exchanges in the developed world prohibit short sales

Explanation

Although there may be limitations on short sales, they are not prohibited by securities exchanges There are more potentialbuyers than sellers of stock so analysts are reluctant to lose these potential customers with a sell recommendation Alsomanagement may hold their firm's stock and options and put pressure on analysts to not issue sell recommendations

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Low tracking risk and high information ratio

Low tracking risk and low information ratio

High tracking risk and low information ratio

ETFs can be more cost effective

ETFs are subject to less regulation

ETFs can be more convenient

Explanation

The review does not specify that ETFs are subject to less regulation than futures ETFs may be more cost effective andconvenient than futures contracts

In which of the following situations would an investor be most risk averse?

When allocating funds to a passive index

When allocating funds to active equity managers

When allocating assets to stocks, bonds, and other assets

Explanation

At the asset allocation level, the focus is on maximizing expected return for a given level of risk Once an investor has made adecision to invest in equity, the tradeoff focuses on active risk and active return As one moves from passive management toenhanced indexing to active management, the expected active return and active risk increase

Investors are more risk averse when facing active risk To believe that an active return is possible, the investor must believethat there are active managers who can produce it and that the investor will be able to pick those successful managers.Second, an active equity style will also be judged against a passive benchmark It is difficult to earn alpha and those investorswho don't will face pressure from their superiors Lastly, higher active returns mean more is invested with the high returnactive manager, and this results in less diversification

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In comparing returns-based style analysis with holdings-based style analysis it is most accurate to say that:

returns-based style analysis can capture changes in style more quickly, but

holdings-based style analysis is more quickly executed

holdings-based style analysis can capture changes in style more quickly, but

returns-based style analysis is more quickly executed

holdings-based style analysis aggregates the effect of the investment process, and

returns-based style analysis is more forward looking

Explanation

Holdings-based style analysis captures changes more quickly because returns-based style analysis uses historical data, andholdings-based analysis is based upon current holdings in the portfolio Holdings-based style analysis requires more time andwork because it requires analyzing each position, and returns-based style analysis uses historical data in a regression.Returns-based style analysis aggregates the effect of the investment process and requires more theory in the process

Which of the following statements regarding using equities as an inflation hedge is most accurate? They have been a goodinflation hedge:

but only in the U.S for a short time span

in many countries over a short time span

in many countries over a long time span

Manager Y because he has more accurate forecasts

Manager X because she has greater breadth

Manager Y because he has greater breadth

Explanation

The information ratio for each manager is calculated as the information coefficient times the square root of the investor'sbreadth:

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information ratio and better performance

If two analysts are classifying a portfolio by style using a style box which of the following statements is most accurate? Thecharacterization of the fund's size will likely be:

the same for each analyst and the characterization of the fund's style will likely

be the same for each analyst

different for each analyst and the characterization of the fund's style will likely be

different for each analyst

the same for each analyst and the characterization of the fund's style will likely be

different for each analyst

Explanation

Categorizing portfolios by size is fairly standard in that market cap is the usual metric for evaluating size However, differentanalysts may use different categorizations of value and growth attributes For this reason, the categorization of portfolios candiffer a great deal depending on the analyst

Which of the following is least likely to be a limitation of an alpha and beta separation approach?

Some long-short strategies may have a degree of systematic risk

The investor may be exposed to systematic risk

It may be difficult to implement in markets

Explanation

One of the main reasons to undertake an alpha and beta separation approach is to gain an exposure to systematic risk (thebeta) through a long position in an equity index The alpha is picked up using a long-short approach

A short extension strategy can be described as:

a long position in equities with a relaxed constraint on short sales

shorting part of the portfolio to reduce exposure to over-valued stocks and gaining

market exposure through the use of derivatives

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going short in part of the portfolio and purchasing an equal amount of equities

resulting in a position that is more than 100% long

Explanation

A short extension is characterized by shorting part of the portfolio, for example shorting 20% and taking the proceeds from theshort sale and purchasing undervalued securities in the same amount so the net amount of capital invested is 100% (= 100%long − 20% short + 20% long) but the long position is 120% (= 100 from the initial long position + 20 from the proceeds of theshort sale) A short extension strategy does not use derivatives but instead only takes long and short positions in equities Amarket neutral strategy is characterized by equal amounts of long and short positions to produce an overall beta of 0 whereas

a short extension strategy has a beta of greater than 0

Harold Bowers, CFA, and Bill Hoffman, CFA, are analyzing the returns of several portfolios Bowers is performing an analysisbased upon the characteristics of the investments in each of the portfolios, and Hoffman is performing a regression analysisusing historical data Based upon this, with respect to returns-based style analysis and holdings-based style analysis, it is mostlikely that:

Bowers and Hoffman are both using variations of holdings-based style

analysis

Bowers is performing returns-based style analysis and Hoffman is performing

holdings-based style analysis

Bowers is performing holdings-based style analysis and Hoffman is performing

returns-based style analysis

Explanation

Bowers is clearly performing holdings-based style analysis Of the two approaches, regression is used in the return's-basedstyle analysis by regressing historical returns on factors

Bob Hageman is the Chief Investment Officer for the pension fund of Wapitechnology Industries Wapitechnology is a producer

of a variety of customized software solutions for service and distribution industries, currently entering its second decade inbusiness Wapitechnology offers a generous defined benefit pension plan, but because of the firm's comparatively recentfounding and the industry in which it operates, Wapitechnology has a very young and mobile workforce Few employees havevested in its pension plan, and no employee has acquired sufficiently long service to retire

The demographics of the defined benefit plan's beneficiaries give Wapitechnology an extremely long time horizon for themanagement of its pension fund Bob Hageman has suggested to Yvette Vargas, Wapitechnology's Chairman and ChiefExecutive, that they should change the investment policy statement for the pension fund to accommodate a higher risk level.Specifically, Hageman thinks that Wapitechnology should increase its asset allocation to equities because the exceptionallylong time horizon of the pension fund enables it to take on an unusually high degree of risk in its investment strategy

Vargas wonders about the suitability of passive management for the Wapitechnology pension fund She points out, "Assetallocation is more likely to favor passive management for taxable investors than for non-taxable investors because of reducedportfolio turnover in a passive management approach."

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Since Vargas is interested in passive investing, Hageman presents the following indexes as possible benchmarks for a passiveportfolio:

Standard & Poor's 500 Composite (S&P 500) US capitalization-weighted

Value Line Composite Average UK equally weighted

Nikkei Stock Average Japan value-weighted

CAC 40 France capitalization-weighted

Dow Jones Industrial Average (DJIA) US price-weighted

He also details the advantages and disadvantages of different types of indexes:

Statement 1: Price-weighted indexes are biased in that higher priced stocks have a greater impact on the index's valuethan lower priced stocks, but the price of a stock is somewhat arbitrary and dependent on splits, stock dividends, andrepurchases

Statement 2: The free float-adjusted index is considered the best type by many investors because it removes the floatfrom the index calculation

Statement 3: A market capitalization-weighted index automatically adjusts for stock splits of individual firms

Statement 4: A price-weighted index must be periodically rebalanced

Hageman explains to Vargas that equity investment approaches can be described by tracking risk and information ratio.Hageman explains, "Tracking risk is the excess of fund return relative to the appropriate benchmark." He suggests to Vargasthat the Wapitechnology pension fund's long time horizon enables them to take on significant tracking risk

Vargas suggests that she thinks they should pay close attention to the information ratio of any equity strategy or manager theyconsider for the pension fund She explains, "Historically, the information ratio has been highest for active management andlowest for passive management, with semi-active management falling in the middle."

Hageman tells Vargas that he has interviewed a wide range of equity managers for potential addition to Wapitechnology'sstable of managers He adds that Cytologic Fund Management has shown an information ratio of 0.082, but says that theirtracking risk recently has been lower than the historical average "If their tracking risk remains low, that would lower theirinformation ratio."

The best description of the accuracy of Hageman's statements regarding the advantages and disadvantages of different types

of equity indexes is:

Statements 2 and 4 are incorrect, Statements 1 and 3 are correct

Statements 1 and 3 are incorrect, Statements 2 and 4 are correct

Statement 2 is incorrect, Statement 1, 3 and 4 are correct

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Statement 2 is incorrect because a free float-adjusted index does not remove the float, it considers only the float Statement 4

is incorrect because an equal-weighted index must be periodically rebalanced Price weighted indexes are adjusted byadjusting the divisor Statements 1 and 3 are correct (Study Session 11, LOS 23.e)

Is Hageman correct with regard to his definition of tracking risk and the impact of tracking risk on the information ratio?

Hageman is incorrect with respect to both statements Active return is the excess return of a manager relative to the

benchmark, and tracking risk is the standard deviation of active return The information ratio is active return divided by trackingrisk, so a decrease in tracking risk would tend to raise, not lower, the information ratio (Study Session 11, LOS 23.b, s)

The primary advantage of a price-weighted index is that it:

is easiest to mimic with minimal tracking risk

implicitly assumes that each investor holds one share of each stock in the index

is computationally simple

Explanation

The primary advantage of a price-weighted index is that it is computationally simple The fact that it implicitly assumes thateach investor holds one share of each stock in the index is generally considered a disadvantage because that approach toinvesting is rarely adopted in practice The best representation of aggregate investor wealth is a market capitalization weightedindex The float-adjusted index is generally viewed as easiest to track (Study Session 11, LOS 23.d)

Is Vargas correct in her statements about the information ratio and the advantage of passive management for taxable

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Vargas is incorrect with regard to the information ratio because, historically, the information ratio has been highest for

semiactive management and lowest for passive management, with active management falling in the middle Vargas is correctthat passive management is more likely to appeal to a taxable investor because of the reduction in capital gains taxes

associated with lower portfolio turnover (Study Session 11, LOS 23.b)

Which of the following best describes of the accuracy of the index data in the table?

The CAC 40 and the Nikkei are incorrect, the others are correct

The Value Line and CAC 40 are incorrect, the others are correct

The Nikkei and Value Line are incorrect, and the others are correct

information that local investors have and thus active investing would be futile and the manager should follow a passive

strategy (Study Session 11, LOS 23.c)

Caroline Corbin has recently come into a large inheritance, and is consulting with her wealth advisor, Kathy Berg, aboutinvesting the allocation to equities Corbin is in her 40s and thus has a very long time horizon for the investment of the funds.Berg has suggested a fairly substantial equity allocation in view of the risk that can be accommodated by this long timehorizon

Berg describes aspects of the investor utility function and allocation process for active risk:

Statement 1: If an investor wants higher active return positions, he must be willing to give up some diversification acrossmanagers

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Statement 3: Utility of active return decreases as active return increases and as active risk decreases

Statement 4: Investors are usually less risk averse when facing active risk than they are when dealing with total risk

Corbin asks about the possibility of employing a core-satellite approach, which uses a core stable of active managers and arotating stable of satellite active managers Corbin points out, "In a core-satellite approach, the core is benchmarked to theasset class benchmark, and the satellites are benchmarked to a more specific benchmark."

Berg provides the following table of active managers for Corbin's consideration, along with a potential allocation approach:

Manager Expected Active Return Expected Active Risk Allocation

Hardley Management 1.50% 2.20% 20%

Noskia Investment Advisors 3.80% 7.10% 25%

Triumphant Returns Partners 2.75% 4.25% 15%

Goodright Wynnes Partnership 2.20% 3.20% 15%

Corbin complains about the proposed asset allocation and selection of managers, saying, "The information ratio of thatportfolio would be approximately 1.1." She suggests to Berg that they should calculate the true information ratio:

True information ratio = True active return / Misfit active return

Berg completes her description of the equity allocation process to Corbin by explaining, "Once the investor has made adecision to invest in equity, the tradeoff between risk and return focuses on active risk and active return." Corbin rephrases thecomment back to Berg, saying, "The investor needs to decide how to maximize active risk relative to a passive managementbaseline."

Expected active return and expected active risk for the allocation shown in the table are closest to:

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(Study Session 11, LOS 23.r)

Are Corbin and Berg correct in their description of active risk and the equity allocation process?

Which of the following least accurately describes a completeness fund?

Complements the active portfolio so that the combined portfolios have a risk

exposure similar to the benchmark

Active return can be maintained while active risk is minimized

Increases misfit risk

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Is Corbin correct in her description of how a core-satellite approach is implemented and how it is benchmarked?

Statements 1 and 3 are correct, Statements 2 and 4 are incorrect

Statement 1 is correct, Statements 2, 3 and 4 are incorrect

Statements 1, 2 and 3 are incorrect, Statement 4 is correct

Explanation

Statement 1 is correct Statement 2 is incorrect because it is possible to use efficient frontier analysis to plot and analyzeactive return and active risk using combinations of available equity managers Statement 3 is incorrect because utility of activereturn increases as active return increases and active risk decreases Statement 4 is incorrect because investors are usuallymore risk averse when facing active risk than total risk (Study Session 11, LOS 23.q)

Which is the most accurate description of Corbin's statements regarding the information ratio and true information ratio?

The value of 1.1 for the information ratio is correct, but the formula for the true

information ratio is incorrect

Both statements are correct

Both statement are incorrect

Explanation

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investor can change his or her social screen and the manager can determine

the appropriate benchmark

portfolio manager can take steps to minimize the bias and the manager can suggest

alternative socially responsible portfolios to the investor

portfolio manager can take steps to minimize the bias and the manager can determine

the appropriate benchmark

Explanation

Socially responsible portfolios tend to be biased towards growth and small-cap stocks The benefits to monitoring this stylebias are that the portfolio manager can take steps to minimize it and can determine the appropriate benchmark for the sociallyresponsible portfolio

An investment management firm is preparing to hire an independent analyst to recommend security selections for the firm'sportfolio The firm would like to keep the manager's compensation straightforward and predictable Which of the following bestdescribes the firm's situation? The investment management firm wants to hire a:

buy-side analyst and pay them for each piece of researched purchased

sell-side analyst and pay them performance-based fees

buy-side analyst and pay them on an ad valorem basis

Explanation

Sell-side analysts often work for an investment bank that uses the research to promote stocks the bank is selling Sell-sideresearch is also conducted by independent firms available for hire by investment managers as in this case Ad valorem feesare based on assets under management thus are straightforward and predictable This is useful when the investor is

budgeting investment fees Performance-based fees are more complex to administer but since the analyst is not managingany assets they could be paid partially based on the performance of their recommended investments

If an investor wanted to equitize a market neutral long-short strategy with a S&P 500 futures contract, which of the followingwould be the correct amount of the notional principal of the S&P 500 futures contract?

The value of the long position

250 times the value of one contract

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